chapter 1siteresources.worldbank.org/psglp/resources/chap1.pdf · the financial system in...

13 Prepared by Dr. Md. Habibur Rahman, Senior Research Economist.

1. Bangladesh Bank2. All Banks3. NBFIs4. Money Changers and5. Credit Rating Agencies

1. SEC2. Stock Exchanges: DSE & CSE3. ICB and4. Merchant Banks

1. Controller of Insurance2. General and Life Insurance Companies

1. NGO Affairs Bureau2. PKSF3. Grameen Bank 4. BRDB and Other NGOs & MFIs

Source: PAU, Bangladesh Bank

Financial Sector in Bangladesh

Box – 1.1

Micro-financial Market

InsuranceMarket

CapitalMarket

Money and ForexMarket

Chapter 1

The Macro-Financial Environment

1.1 A Brief Sketch of the Financial Sector in Bangladesh 13

(a) Background

The financial system in Bangladesh embraces four categories of scheduled banks, various co-operative banks, non-bank financial institutions, insurance companies, credit rating agencies and two stock exchanges. In addition to the Bangladesh Bank (the Central Bank of Bangladesh), there are 4 NCBs, 5 state owned SBs, 30 domestic PCBs, 9 FCBs and 28 NBFIs as on 31st December 2005. Box-1.1 briefly presents these financial market players in an organized way.

1

14 The remainder of the topics that follow in this section are dealt with in greater depth in the subsequent chapters of the current issue of the Financial Sector Review (FSR). Here a preliminary sketch is given by way of a quick review.

(b) Central Bank and its Policies

Bangladesh Bank (BB), as the central bank, has legal authority to supervise and regulate all banks and non-bank financial institutions. It performs the traditional central banking roles of note issuance and of being the banker to the government and banks. Given some broad policy goals and objectives, it formulates and implements monetary policy, manages foreign exchange reserves and lays down prudential regulations and conduct monitoring thereof as they apply to the entire banking system. Its prudential regulations include, among others: minimum capital requirements, limits on loan concentration and insider borrowing and guidelines for asset classification and income recognition. The Bangladesh Bank has the power to impose penalties for non-compliance and also to intervene in the management of a bank if serious problems arise. It also has the delegated authority of issuing policy directives regarding the foreign exchange regime.

(c) Interest Rate Policy14

Under the new interest rate policy which became effective in January 1990, all deposit rates have been decontrolled. Lending rates are all freely determined by the market, except for exports. With effect from January 2004, the interest band for all sorts of export credit has been revised downward to 7 percent. With a view to establishing a transparent and easily understandable mechanism in fixing interest rates, banks are required to declare a mid rate of the highest and lowest band since January 2004.

(d) Capital Adequacy Ratios

In January 1996, BB announced a new policy on Capital Adequacy along the lines recommended by the Basel Committee on Banking Supervision. The revised policy on capital adequacy requires scheduled banks to maintain at least 9 percent of off-balance sheet risk and risk in different types of assets as capital (with at least 4.5 percent in core capital) or BDT 1.00 billion whichever is higher.

(e) Loan Classification and Provisioning

Bangladesh Bank introduced new accounting policies with respect to loan classification, provisioning and interest suspense in 1989 with a view to attaining the relevant international standards over a period of time. A revised policy for loan classification and provisioning was introduced from 1st January, 1999. The revised policy calls for an independent assessment

Chapter 1 (Continued)

2

of each loan on the basis of qualitative factors and objective criteria. Each loan is branded with the worst level of classification resulting from these independent assessments.

If a Continuous Credit or a Demand Loan remains non-performing for 6 months or more it is classified Sub-standard. It is classified as Doubtful if it remains non-performing for 9 months and classified as Loss if non-performing for 12 months or more.

In the case of a Term Loan, which is repayable within a maximum period of 5 years, if any instalment is not repaid within the specified period and if the time-equivalent of such unadjusted balance is 6 months, it is classified Sub-standard. A Term loan is classified Doubtful and Loss if the time-equivalent of unadjusted balance is 12 months and 18 months, respectively. Agricultural Loan and Micro-Credit is classified Sub-standard if non-performing for 12 months, Doubtful if non-performing for 36 months and Loss if non-performing for more than 60 months.

Under the existing system scheduled banks are required to maintain provisions against unclassified and substandard loans in addition to doubtful and loss loans. They are allowed to book interest against classified loans only on cash basis. Whether a credit is classified or not under the objective criteria, it is subjected to classification under qualitative judgement if any doubt arises regarding repayment of the loan.

(f) Foreign Exchange System

On March 24, 1994 Bangladesh Taka (BDT, the domestic currency) was declared convertible for current transactions in terms of Article VIII of the IMF Articles of Agreement. Accordingly, current external settlements for trade in goods and services and for amortization payments on foreign borrowings can be made through the authorized dealers (ADs) to deal in foreign exchange, without prior central bank authorization. However, because resident-owned capital is not freely transferable abroad (BDT is not yet convertible on the capital account), some current settlements beyond certain indicative limits are subject to bonafide cheques.

Direct investments of non-residents in the industrial sector and portfolio investments of non-residents through stock exchanges are repatriable abroad, as also are capital gains and profits/dividends thereon. Investment abroad of resident-owned capital is subject to prior Bangladesh Bank approval, which is allowed only sparingly.

(g) Exchange Rate Policy

The exchange rate policy of Bangladesh Bank aims at maintaining the competitiveness of Bangladeshi products in the international markets,


3

encouraging inflow of wage earners' remittances, maintaining internal price stability, and maintaining a viable external account position. Prior to the inception of floating exchange rate regime, adjustments in exchange rates were made while keeping in view the trends of REER index based on a trade weighted basket of currencies of major trading partners of Bangladesh and the trends of other important internal and external sector indicators. However, the interbank foreign exchange market sets the exchange rates for customer transactions and interbank transactions based on demand-supply interplay; while the exchange rates for the Bangladesh Bank's spot purchase and sales transactions of US Dollars with ADs is decided on a case to case basis. Bangladesh Bank does not undertake any forward transaction with ADs. The ADs are free to quote their own spot and forward exchange rates for interbank transactions and for transactions with non-bank customers.

(h) Bank Licensing

Bank Company Act, 1991, empowers Bangladesh Bank to issue licenses to carry out banking business in Bangladesh. Pursuant to section 31 of the Act, before granting a license, Bangladesh Bank needs to be satisfied that the following conditions are fulfilled: “that the company is or will be in a position to pay its present or future depositors in full as their claims accrue; that the affairs of the company are not being or are not likely to be conducted in a manner detrimental to the interest of its present and future depositors; that, in the case of a company incorporated outside Bangladesh, the Government or law of the country in which it is incorporated provides the same facilities to banking companies registered in Bangladesh as the Government or law of Bangladesh grants to banking companies incorporated outside Bangladesh and that the company complies with all applicable provisions of Bank Companies Act, 1991.” Licenses may be cancelled if the bank fails to comply with above provisions or ceases to carry on banking business in Bangladesh.

(i) Commercial Banks

The commercial banking system dominates Bangladesh's financial sector with a limited role of NBFIs and the capital market. The banking sector alone accounts for a substantial share of assets of the financial system. The domination of the banking system by the NCBs is declining while PCBs is gaining the bulk of the market share in recent years reflecting increased competitive environment in the banking industry. Recent data show that 4 NCBs, 30 PCBs and 9 FCBs comprising about 37 percent, 46 percent and 7 percent respectively of total assets as of end December 2005.


4

15 Note that as of end February 2006 some 213 of the DSE listed companies also listed in the CSE.

(j) State Owned Specialized Banks (SBs)

Out of the 5 (five) state owned specialized banks (enjoying 10 percent of the total industry’s asset), Bangladesh Krishi Bank (BKB) and Rajshahi Krishi Unnayan Bank (RAKUB) were created to meet the credit needs of the agricultural sector while Bangladesh Shilpa Bank (BSB) and Bangladesh Shilpa Rin Sangstha (BSRS) were set up for extending term loans to the industrial sector.

(k) Non-Bank Financial Institutions (NBFIs)

As per licenses issued by the Bangladesh Bank under Financial Institutions Act 1993, as of 30 June 2005 there were 28 financial institutions operating in Bangladesh. Of these institutions, 1(one) is government owned, 15 (fifteen) are local (private) and the other 12 (twelve) are established under joint venture with foreign participation. Bangladesh Bank has introduced a policy for loan and lease classification and provisioning for NBFIs from December 2000 on a half-yearly basis. To enable the financial institutions to mobilize medium and long-term resources, Government of Bangladesh (GOB) signed a project loan with IDA, and a project known as “Financial Institutions Development Project (FIDP)” has started its operation from February 2000. The project has established “Credit, Bridge and Standby Facility (CBSF)” to implement the financing program.

(l) Capital Market

The Capital market, an important ingredient of the financial system, plays a significant role in the economy of the country. At the capital markets end, the SEC exercises powers under the Securities and Exchange Commission Act, 1993 as the regulatory body overseeing activities of the stock exchanges and financial institutions operating in the capital market. Capabilities of the SEC are in the process of being beefed up and upgraded. The SEC so far has issued licenses to 27 institutions to act in the capital market of which 19 institutions are Merchant Banker and Portfolio Manager while 7 are Issue Managers and 1(one) acts as Issue Manager and Underwriter. There are two stock exchanges, namely, the Dhaka Stock Exchange (DSE) and the Chittagong Stock Exchange (CSE) which deal in the secondary capital market. DSE was established as a Public Limited Company in April 1954 while CSE in April 1995. As of end February 2006 the total number of enlisted securities with DSE was 296 of which 253 were listed companies, 13 mutual funds, 8 debentures and 22 treasury bonds.15 The Investment Corporation of Bangladesh (ICB) was established in 1976 with the objective of encouraging and broadening the base of industrial


5

investment. ICB underwrites issues of securities, provides substantial bridge financing programs, and maintains investment accounts, floats and manages closed-end and open-end mutual funds and closed-end unit funds to ensure supply of securities as well as generating demand for securities. ICB also operates in the DSE and CSE as dealers. Some SBs, such as Bangladesh Shilpa Bank (BSB), Bangladesh Shilpa Rin Sangstha (BSRS), Bangladesh Small Industries and Commerce (BASIC) Bank Ltd. as well as NCBs and some Foreign Banks are engaged in long-term industrial financing.

(m) Insurance

The insurance sector is regulated by the Insurance Act, 1938 with regulatory oversight provided by the Controller of Insurance on authority under the Ministry of Commerce. General insurance is provided by 44 companies and life insurance is provided by 18 companies. The industry is dominated by the two large, state-owned companies—Sadharan Bima Corporation (SBC) for general insurance and Jiban Bima Corporation (JBC) for life insurance—which together command most of the total assets of the insurance sector.

(n) Microfinance Institutions (MFIs)

The member-based Microfinance Institutions (MFIs) constitute a rapidly growing segment of the Rural Financial Market (RFM) in Bangladesh. At present, Grameen Bank is the only formal financial institution among them, established in 1983 under a special law with the initial support from the Bangladesh Bank. The typically landless borrowers of Grameen Bank who are mostly women who own the bank and it is the pioneer organization of this type. Besides this Grameen Bank, there are more than 1000 semi-formal institutions operating mostly in the rural sector of the country; BRAC, ASA, and PROSHIKA are considered three largest NGO-MFIs. These institutions have an explicit social agenda to cater to the needs of the poorer sections of population, and have a focus towards women clients.

At present NGO-MFIs are not regulated or supervised or monitored by any single authority in Bangladesh; they are under the system of off-site supervision by the authorities that provide them registration as non-government organizations (NGOs). However, the regulatory issue has come to the forefront because MFIs are providing financial services and products to the poor, outside the formal banking system. Considering the need to develop an appropriate regulatory and supervisory system for this sector the Government of Bangladesh has established a Unit named “Microfinance Research and Reference Unit (MRRU)” at the Bangladesh Bank. A national


6

16 Prepared by Dr. Md. Akhtaruzzaman, Senior Research Economist.

0.0

1.0

2.0

3.0

4.0

5.0

Australia Britain Germany Japan United States Euro Area

Latest Q4-2005 2006 2007

Figure-1.2.1aGDP Forecast for major OECD countries

Source: The Economist, 17th June, 2006

Steering Committee was formed to administer the Unit and to formulate policy guideline which was also responsible to make suggestions for a regulatory framework for the sector. The Committee has completed its term in June 2005 but the Unit is still active. Currently the Unit is working under the direct supervision of the Governor of the Bank.

The unit has already published an operational guideline for these NGO-MFIs with the help of the committee and has been collecting half-yearly information since January 2004 on management, savings, credit, income, expenditure and balance sheet items. The unit is also providing training to these institutions on the operational guideline supplied to them. The committee has submitted a draft law to the Government which has recently been approved by the cabinet. It is expected that after the promulgation of the law, this sector will be under a formal financial system in near future. All these programs mentioned above (guideline, training and information collection) going on under the unit are being considered as the background work towards the formulation of a full-fledged regulatory framework for the microfinance sector in Bangladesh.

1.2 Current World Growth Outlook and the Global Environment 16

(a) World Growth Outlook for FY06

Developments in global economy since 2003 have been in the positive direction, supported by the strong growth performance in both sets of countries which are the principal destinations as well as competitors of Bangladesh's exports such as United States (US) and some euro area countries especially Britain, Denmark, Sweden and Switzerland and the


7

growth outlook of all these countries for 2006 have been adjusted upward. Growth performance for 2005 in other euro area countries however has been modest with the continuing weakness in three european giants like Germany, France and Italy. However, in the euro area as a whole, a recovery is underway and the growth outlook is projected at a higher rate of 1.7-2.5 percent in 2006 and 1.5-2.5 in 2007. There is also some recent signs of upturn in Japan which is becoming more firmly entrenched with real output growth rising by 2.7 percent in 2005 on top of 2.6 percent in 2004 that considerably brightens the outlook for its own economy as well as the global economy.

Among Bangladesh's major regional trade partners, India, Pakistan and Sri Lanka and also to a lesser extent China, South Korea and Thailand are important. On average developing Asia's growth rate is also expected to be quite robust in the year 2006. Among the Asian countries particularly China's and India’s GDP growth rates for 2005 and 2006 remains robust and broadly on trend average (see Figure-1.2.1b). For example, China’s growth record in the fourth quarter of 2005 is highly significant (9.9-percent) who has sustained its dynamism in achieving high output growth in current year and therefore the near term GDP outlook for 2006 is expected to be even brighter with spectacular growth achievement of 16.2 percent in industrial production during January-February, 2006. India has recorded a growth rate of 7.5 percent during 2004 and for 2005 the growth rate has adjusted upward at around 8.1 percent. Pakistan also recorded a higher growth rate of 8.4 percent during 2005. Both for India and Pakistan the growth outlook is shown brighter in 2006. Other Asian growth nodes such as Sri Lanka, Hong Kong, Malaysia, Singapore, Taiwan, South Korea, Philippines and Thailand have also registered high growth rate in the fourth quarter of 2005. The near term outlook of the output growth in the Asian region as a whole is positive with significant industrial output growth in India (8.3 percent), Pakistan (19.3 percent), South Korea (6.4 percent) and Thailand (8.3 percent) during January February 2006.


8

Figure-1.2.1bGDP Forecast for major Asian countries

02468

10

AsiaCountry

Real

GD

P

2006

Bangladesh India Pakistan SriLanka China Thailand Developing

2005

Source: World Economic Outlook-September, 2005, IMF

17 For the year 2007 The Economist's poll GDP forecast figures have shown a slower growth rate for world output. 18 CESifo Press Service- http://www.cesifo.de/cesifo/newletter/GlobalImbalances.htm

Following a temporary slow down in mid-2004, global GDP growth remains broadly on track and in the backdrop of such rebound of growth prospect in most of the growth nodes in 2005 global output growth forecasts for 2006 largely adjusted upward to 4.3 percent from the annualized growth estimates of fourth quarter of calendar 2005, with robust service sector output more than offsetting slowing global growth in manufacturing and, lately, trade17 (see Figure-1.2.1a). However, sources of risk to the world economy include high oil prices, the possibility of a disorderly adjustment of global macroeconomic imbalances, and the adverse implications of investors’ continued search for high financial returns on their portfolios in recent months.

In terms of financial markets, an important dimension of the huge current global imbalances is the high level of international reserves held in dollar assets. At the same time, there has been a strong expansion of cross-border holdings of financial instruments, doubling since 1990 from about 60-percent of the world GDP to above 120-percent now.18 Thus low long-term yields could persist (flattening of the yield curves) in the wake of building-up of leverage in international financial markets and continue to underpin the search for higher returns of riskier assets through increasingly complex and leveraged strategies. Therefore, the market expects only a moderate interest rate hike in the medium term though in the downside an unexpectedly sharp rise might lead to a significant deterioration of the creditworthiness of borrowers overall. The above risk factors underscore the need for proper assessment of the future developments in the global financial markets and also the need for vigilance by supervisors and regulators.

(b) Outlook for FY06 Global Financial and Equity Market Development

Against the backdrop of higher oil prices and their volatility together with the further widening of the US current account deficit and higher investor risk appetite, there has been increased economic and financial uncertainty. Long-term interest rates, while volatile, continue to be unusually low around the world with yield curves flattening. The changes in policy are thus required to afford an upward revision of long-term rates and are likely to differ across countries. Nevertheless, these developments have forced different central banks of the OECD countries including euro area central banks, European central banks, bank of Japan and the US Federal Reserve (“the Fed”) to tighten monetary policy. The Fed has raised its policy rate (the federal fund rate) by 25 basis points each on thirteen occasions from 1.25


9

percent at the start of the tightening cycle launched in June 2004 to 5.0 percent by mid-June 2006. The European Central Bank (ECB) has raised policy rates (both short-term and long-term) by 25 basis points to 2.75 percent in mid-June, 2006 in response to rising inflationary expectations, after holding it unchanged at 2.0 percent since June 2003. The Bank of England has kept its repo rate unchanged at 4.95 percent since May 2006 in response to slowing domestic growth.

Monetary policy has been tightened also in several economies in emerging Asia, primarily in response to higher fuel prices and to the measured pace of policy tightening in the US as well as euro area countries. India, South Korea, Thailand and China have maintained short-term interest rates which are very low as compared to many Asian countries like Pakistan, India and Indonesia. Pakistan's short-term interest rate rose to as high as 9.26 percent in mid-June 2006. India’s Reserve Bank has very recently raised its short term rate and also repo rate to 6.22 and 6.17 percent respectively in March 2006. Indonesia raised its policy rate by 50 basis points to 13.21 percent on mid-June, 2006. In Thailand, the 14-day repo rate was increased to 5.35 percent on mid-June 2006. In Malaysia, the policy rate was raised to 3.9 percent in mid- June, 2006. In emerging market economies in general, the direction of policy change has been towards either tightening or withdrawal of the accommodative stance.

Global investment and savings patterns have played a central role in the long downward trend in the ‘risk-free’ long-term (treasury bonds, public securities etc.) interest rates. One frequently cited view is that the rise in saving in emerging market economies (EMEs) has led to a global “savings glut”, driving down global interest rates and through its effect on asset prices contributing to the steady fall of bond interest rate in developed economies. In spite of low long-term interest rates, investment rates have declined in the euro area and East Asia (excluding China) indicating sluggish future growth prospect. And saving rates have increased in EMEs, particularly in China, in contrast to the sharp decline in the US. A variant of this view is that there is an “investment drought” outside the US. Rising oil prices have further reinforced this pattern, increasing saving in oil-producing countries and potentially detracting from investment in the major industrial countries.

Consistent with the current pattern of global savings and investment, net corporate debt issuance, in recent years, have been scarce relative to net issues of low-risk government bonds. As a result, investors have sought to leverage existing assets in their quest to enhance potential returns. The continued willingness of foreigners to invest a large proportion of their savings in US assets, and so satisfy the external financing needs of the US,


10

remains a potential vulnerability. Without any fiscal rebalancing in the US, a reduction in Asian saving, possibly associated with a slowdown or reversal in reserve accumulation, increases the risks of financial strain in the global currency and asset markets. In the backdrop of such asset price risk market participants have suggested that private sector investors in US assets, perhaps especially in Asia, may be increasingly exposed to exchange rate risk. Asian central banks in an effort to prevent their currencies from appreciating abruptly have been actively buying U.S. assets. Even so, capital inflows to the US have remained strong, aided by robust private and official flows. But sudden shifts in international capital flows could disrupt a wide range of asset markets and could create difficulties for firms and lenders, particularly as they increase their exposure to new and more illiquid financial products. The longer these imbalances continue, the greater the potential for costly and disorderly adjustments in markets and thus in the balance sheets of global financial institutions.

Nevertheless, global equity markets have remained resilient, supported by strong corporate profits and increasingly solid balance sheets; and, apart from some rise in high yield spreads, globally credit spreads remain moderate. Improved corporate profit and continued favorable financing conditions have contributed to a further decrease in various indicators of global financial distress, such as default rates. Moreover, the stock markets reported a slight upswing accompanied by a substantial drop in volatility. Above all, the global stock markets have remained stable in 2005 and early 2006 as in 2004. Equity markets rebounded strongly since November, 2005, boosted by signs of still robust growth in the US. By late November, the US equity and bond prices had returned to their end-September highs


11

Figure-1.2.2 Three months Money Market Rate for OECD countries

Source: The Economist, 17th June, 2006. CPI Inflation rates are 3.2-percent for US, 1.7-percent for euro area, 2.7-percent for Switzerland, 2.9-percent for Sweden, 4.0-percent for Japan, 3.7-

percent for Denmark, 2.9-percent for Canada, 1.8-percent for Britain and 2.7-percent for Australia

01234567

Australia Britain United States Euro Area

Inte

rest

rate

% a

yea

r

Latest Year ago

19 Source: The Economist, 17th June, 2006

and had generally reached record levels by January-February 2006. But since the second quarter of 2006 the stock prices (S&P 500 Index) again started falling and by mid-June 2006 it registered a record rate of around 20 percent negative growth.

Though Japan outperformed most other equity markets throughout the first quarter of 2006 but its stock prices (Nikkei 225) also moved down significantly by mid-June, 200619. In the Asian stock markets the emerging market economies’ (EMEs) record is also highly negative in the said period. The composite index of EMEs, EM(MSCI), has declined by 4.7 percent during second quarter of 2006 and has continued to decline. Asia's most giant China has recorded a positive gain of 2.5 percent in stock prices and India’s stock price indices moved down by 3.6 percent during second quarter of 2006.

(c) Global Trade Growth and BOP Outlook for FY06

Global current account (CA) imbalances-a key medium-term risk to the outlook-have increased yet again. As of end December 2005 the current account deficit in the US ran a record of $805 billion, up from $668 billion in 2004; as a share of GDP the deficit rose to 6.4 percent from 5.7 percent. Further, the US current account deficit rose to $8.15 billion in the first quarter of 2006 and is projected by the OECD to exceed 7.0 percent of GDP in 2007 with substantial surpluses elsewhere. And the combined CA surplus of the ten largest oil-exporting countries is now higher, in dollars terms, than that of the Asian economies as a whole. A moderately slower growth of exports from both the advanced economies and other EMEs and developing countries is projected to remain at a high level for the latter group of countries. Net capital flows to EMEs this year have been buoyant, returning to the pre-Asian crisis levels. Similar experience has been enjoyed by Singapore, Saudi Arabia, and Brazil among other. Russia’s trade surplus is even bigger: it rose to $ 124.3 billion in the year to January 2006. One factor contributing to the persistence of global imbalances has been the desire of surplus countries to limit the appreciation of their exchange rates.

Current account balances of South Asia countries are continuing to be in deficit for most of the countries such as Bangladesh, India, Sri Lanka, Pakistan etc. But developing Asia as a whole is in surplus because China has been outperforming in recent years. For example, China’s 12-month current account surplus recorded strong positive growth reaching USD 128.5 billion by the second quarter of 2006.


12

20 For example, the ratio of reserves to short-term external debt in China and South Korea is now 6.0 and 2.8 percent respectively.

Figure 1.2.3 Current Account Balance of Major South Asian Countries


-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

Bang

lade

sh

Indi

a

Paki

stan

SriL

anka Chi

na

Thai

land

Dev

elop

ing

Asia

2005 2006

Cur

rent

Acc

ount

Bal

ance

Foreign exchange reserves have been building up in a large number of EMEs, in some cases to levels well above those that would likely be required to withstand temporary balance of payments shocks.20 The majority of these reserves have been invested in dollar-denominated securities, although there have been signs of a gradual diversification in recent years. Data from the US Treasury show that oil exporters’ (including Norway and Mexico) net holdings of US Treasury securities grew by two thirds in 2004 though this accumulation has eased significantly during 2005. However, oil exporters have spent a larger proportion of the increase in income from oil exports and this has limited the adverse impact of high oil prices on world activity and CA imbalances. The European Union has benefited the most, in US dollar terms, from increase in demand for their products from oil exporting countries.

In the wake of further rise in the US current account deficit, the US dollar depreciated modestly by less than 3 percent in trade-weighted terms during the second quarter of 2006. Movements in industrial country currencies varied widely, with the Canadian dollar appreciating modestly and the yen depreciating significantly in the second quarter of 2006. The euro also depreciated modestly in the same period, the latter seemingly reflecting increasingly unfavorable short-term interest rate differentials.

The global foreign exchange market and the balance of payments situations warrant that a combination of real exchange rate depreciation and a reduction in domestic spending in deficit countries and the opposite in surplus countries are likely to be initiated though it would take same time to achieve the intended results. With luck, the resolution of current imbalances may proceed relatively smoothly with sound exchange rate and


13

Figure-1.2.4Exchange Rate (trade weighted, 2000=100) for OECD Countries


020406080

100120140

Australia Britain Germany Japan UnitedStates

Euro Area

Exch

ange

rate

(tr

ade

wei

ghte

d)

Mar.2006 Mar.2005

monetary policy. However, it is also possible that a “hard landing” occurs. If the crisis is sufficiently severe, however, monetary authorities may face difficult trade-off between financial stability and exchange rate and fiscal stability. Governments may then have to shoulder large fiscal costs to stave off a serious financial crisis.

(d) Global Budgetary Outlook for FY06

Budgetary imbalances are other sources of major macro imbalances ailing the global economy. America’s fiscal deficit reached to 3.7 percent of GDP during 2005 which has been adjusted upward to 4.34 percent in the estimate for 2006. In aggregate, the euro area budget deficit reached to 2.9 percent though Britain, Germany, Italy and France are more prone to fiscal burden. Japan’s budget deficit is the highest, 6.5 percent of GDP during 2005, among the OECD countries. The relatively weak public finances in many European countries are an aggravating factor. Most of the Asian countries have a historical record of large deficit in central government budget. Many argue that the most important policy contribution to adjustment should come from a reduction in the US fiscal deficits. Without any fiscal rebalancing in the US, a reduction in Asian saving, possibly associated with a slowdown or reversal in reserve accumulation, increases the risks of financial strain in the global currency and asset markets.

(e) Global Inflation and Commodity Price Outlook for FY06

Global headline (i,e., CPI) inflation has picked up modestly in the second quarter of 2006 in response to mainly higher oil prices, but the rising unit labor cost in the US has also fuelled it partially. With the moderation in international crude oil prices since September, consumer price inflation in 2006 is projected to remain low (around 2.2 percent) in advanced economies with sound supply condition even in face of strong demand and


14

21 Prepared by Dr. Md. Habibur Rahman, Senior Research Economist.

increasing consumer spending although asset prices, especially housing market prices, remain a cause for concern in terms of potential inflationary pressures and the repercussions on consumer spending and financial sector balance sheets. Japan's consumer prices have got reverse trend by moving up by 0.4 percent in mid-June 2006.

However, inflationary pressures have risen somewhat more in EMEs, with forecasts for 2006 revised upward in most regions. China and India's CPI forecasts show upward trend (increased to 1.2 and 5.0 percent respectively) mainly due to huge demand pressure. Where as Bangladesh and Pakistan's forecasts (6.2 percent) don't show any upward revision. Sri Lanka (2.4 percent) and Thailand's CPI forecast (6.2 percent) shows moderate downward revision for the year 2006. Higher oil prices together with overheating demand pressures in some countries in emerging Asia with large external surpluses are playing an increasing role in price upsurge in these regions. Besides, elevated levels of oil prices, tight non-oil commodity markets have imposed price pressures. In the commodity markets non-fuel commodity prices have picked up in response to both strong demand and supply disruptions. However, with the projected decline in non-fuel commodity prices inflation is projected to decline in both advanced and other emerging markets and developing countries.

1.3 Recent Bangladesh Macro-Financial Developments 21

(a) Background

An efficient and competitive financial sector is one of the keys to economic growth as it facilitates savings and investment. A stronger financial sector is critical to improving income levels. Low-income families, small-to-medium


15

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4

Australia Britain Germany Japan United States Euro Area

Latest year ago 2006 2007

Table-1.2.5CPI Forecast (% change on year ago) for Major OECD Countries


size enterprises, and rural entrepreneurs in a developing country like Bangladesh have difficulty obtaining financial services. By facilitating transactions and making credit and other financial products available, the financial sector is a crucial building block for private sector development which is now widely believed to be the ultimate engine of growth. It can also play an important role in reducing risk and vulnerability, and increasing the ability of individuals and households to access basic services like health and education, thus having a more direct impact on poverty reduction. As the mission is to achieve the Millennium Development Goals (MDGs) and the elimination of poverty by 2015, an assessment of the overall financial sector in Bangladesh is, therefore, crucial. Publishing the Financial Sector Review (FSR) must play a very important role in this regard. The current section of the Review is, therefore, designed in a way that would focus some of the historical aspects as well as recent developments in the macro financial environments in Bangladesh.

(b) Recent Developments

As an integral part of the Financial Sector Reforms Program (FSRP), a series of major policy actions has been taken under the reform program in line with the goals and objectives of medium term macroeconomic policy matrix. The FSRP, which was launched in 1990, has become a continuous process in bringing proper discipline as well as efficiency in the financial sector. The broad objectives of the FSRP are as follows:

• Liberalization of the interest rate structure;• Strengthening of banking inspection and supervision;• Maintenance of capital adequacy requirement;• New system of loan classification;• Restructuring of legal framework in the financial sector;• Development of capital market;• Development of the banking system, and asset quality;• Computerization of central bank as well as commercial banks; and • Domestic and foreign training for the development of bank officials.

As noted above the Financial Institutions Development Project (FIDP), formally launched in February 2000 which is administered by BB, has made substantial improvement towards sustainable financing of private sector initiatives in accelerating industrial growth in Bangladesh.

In recent times, the monetary authority of Bangladesh has pursued a series of Legal, Policy and Institutional reforms to improve the process of financial intermediation and ensure efficient allocation of financial resources and in the ultimate analysis improve the competitiveness of the private sector and thereby promote investment and growth in the real sector. The thrust of the reform program is to improve the environment for, and the ability of bank owners, bank management, bank regulators and the markets to provide for


16

22 Prepared by Shamim Ahmed, Research Economist23 In this section, by "commercial" lending and deposit rates we mean the monthly weighted average rates of seven major scheduled banks of the country. On the other hand, the weighted average of lending and deposit rates for all scheduled banks in the country is calculated only on a quarterly basis.

better governance and regulation to achieve the above- mentioned objectives. The reform program focuses on: (i) greater autonomy to the Bangladesh Bank (BB); (ii) strengthening of the BB's capabilities and technical skills to perform its enhanced responsibilities; (iii) strengthening prudential regulations and supervision; (iv) restructuring the management and internal processes of NCBs and ultimately privatization of selected NCBs and SBs; (v) strengthening the legal and judicial processes and (vi) improving the money and debt markets.

(c) The Interest Rate Structure 22

Under the Financial Sector Reform Program of 1990, the BB has implemented significant policy changes, especially, policies towards achieving macroeconomic stability along with an efficient money market in the country. The major change has been to affect the structure of deposit and lending rates by indirect rather than direct measures. Among the indirect tools of the primary monetary policy instruments, namely, the various short-term rates (i.e., repo and reverse-repo rates) that affect the liquidity position in the overnight market, and in principle the borrowing and lending rates facing both consumers and producers in the economy. Then there are the remaining tools of monetary control such as the CRR, SLR ratios, and the bank rate (i.e., the rediscounting rate).

As part of these changes, commercial banks have been allowed to set the interest rates (i.e., lending and deposit rates) in line with market conditions, which were previously determined by the BB. In view of growing importance of financing the budget deficit through borrowing from the non-bank public, recently commercial banks appear to adjust the deposit rates (and hence the lending rates) in response to changes in the rate of NSD certificates. Given that the latter are of 3 and 5-year terms, one would expect only a muted effect on short-term deposits (i.e., less than 6-months). However for terms longer than one year, the changes appear to be in the same direction and by a comparable magnitude.

Correspondingly to the above hypothesis, it turns out that major shifts in the nominal level of both commercial bank lending and deposit rates over the last 2-3 years have followed the NSD rate schedule fairly closely.23 From Figure 1.3.1 it is seen that there has been a sharp decline both the nominal lending and deposit rates during the first quarter of calendar 2004, which matches the fact that the NSD rates were reduced by 1.5 percentage points as of January 1, 2004. The NSD rates declined by a further 50-basis points on July 17, 2004, and we note a continuation of


17

24 Particularly, the monthly commercial lending and deposit rates rose to 10.75 percent and 5.65 percent, respectively in December, 2005 from April, 2005 figures of 10.53 percent and 5.46 percent, respectively.25 However, the situation has changed dramatically since on December 12, 2005 the MOF raised the rate on NSD certificates and similar instruments by 1.5 percentage points, which have led to adjustments in all deposit rates at most financial institutions. These issues are further reviewed in Chapter 3.

-4-202468

101214

Commercial Lending Rate Commercial Deposit RateCommercial Real Lending Rate Commercial Real Deposit Rate

Jul-02

Oct-02Jan-03

Apr-03

Jul-03

Oct-03Jan-04

Apr-04

Jul-04Oct-0

4Jan-05

Apr-05

Jul-05Oct-0

5Jan-06

Figure 1.3.1Nominal and Real Interest Rates: “Commercial” Lendingand

Deposit Rates (monthly weighted average in percent).

Note: 1. Monthly real rates have been calculated by subtracting monthly inflation rate (measured by 12 months average CPI, base: 1995-96=100) from the respective monthly nominal rates.

Source: Constructed based on data from Monetary Policy Department and Economic Trends, Bangladesh Bank.

the rather gradual declining trend in the nominal rates before stabilising as of April 2005 (Figure 1.3.1), even registering a small increase.24 The latter behaviour was therefore due to real and/or monetary policy factors rather than fiscal policy.

However, it is also observed that the commercial real (i.e., inflation adjusted) lending and deposit rates have continued to decline all the way to end-December, 2005 such that the real deposit rate turned negative starting from June 2004. In particular, commercial real lending and deposit rates fell to 3.71 percent and (-)1.39 percent, respectively in December 2005 compared to 4.54 percent and (-)0.94 percent during the same month of the preceding year. Moreover, all the above observations remain valid when lending and deposit rates (calculated on a quarterly basis) of all scheduled banks in the country are considered (Figure 1.3.2). If this situation were to persist, private savings would likely have been discouraged over the immediate future, which in turn, would have had an adverse effect on private sector investment as well as the macroeconomic health of the economy.25 Finally, it is also noticeable that the gap between the two rates (often called the banking spread) remains high over the years (Figure 1.3.1 and 1.3.2), a point that is investigated in more detail in chapter 3.


18

26 See Monetary Policy Review (October 2005), chapter 3 for an elaboration.

In actual practice the overnight market appear not to directly influence the lending and deposit rates prevailing in Bangladesh.26 However, from the savers' perspective a significant substitute of private bank deposits appears to be NSD certificates of different maturities, and others of this genre, especially, the postal savings certificates. In response to the December 2005 increase, net sales of NSD certificates during January-February of 2006 rose to BDT 11.39 billion as compared to BDT 7.65 billion in the corresponding period of 2005, i.e., an increase of 73 percent. Sales and redemption of NSD certificates during the July-December period of 2005 stood at BDT 60.04 billion and BDT 52.02 billion respectively compared to BDT 47.43 billion and BDT 38.58 billion during the same period of the preceding year. Therefore, net borrowing (i.e., net sale) through NSD certificates during July-December, 2005 stood lower at BDT 8.02 billion compared to BDT 8.85 billion during the same period of the preceding year, i.e., a decrease of 9.4 percent in nominal terms. However, net borrowing through this instrument during July 2005 to February 2006 stood higher at BDT 19.41 billion compared to BDT 15.44 billion during the same period of the preceding year, i.e., an increase of 25.7 percent. This indicates a significant shift of private savings toward NSD certificates.

If the pattern of lending and deposit rates of the country is compared with that in India, Pakistan, and Sri Lanka, an interesting picture is observable.


19

-2

0

2

4

6

8

10

12

14

Lending Rate Deposit Rate Real Lending Rate Real Deposit Rate

Jun-

03

Aug-0

3

Oct-03

Dec-0

3

Feb-

04

Apr-04

Jun-0

4

Aug-0

4

Oct-04

Dec-0

4

Feb-

05

Apr-05

Jun-0

5

Aug-0

5

Oct-05

Dec-0

5

Figure 1.3.2 Nominal and Real Interest Rates (All Banks): Lending and

Deposit Rates (quarterly weighted average in percent)

Note: 1. Quarterly real rates have been calculated by subtracting quarterly inflation rate (measured by 12 months average CPI, base: 1995-96=100) from the respective quarterly

nominal rates.


For instance, in India, lending rates and deposit rates in nominal as well as real terms are more or less similar to those of Bangladesh with a few exceptions. In particular, nominal prime lending rates of public sector banks were within the range of 10.25 to 11.25 percent and deposit rates of various maturities were within the range of 2.75 to 7 percent during December 2005.27 Moreover, real lending and deposit rates in India have also continued to decline due to inflationary pressure although they were higher than those in Bangladesh, Pakistan and Sri Lanka. In contrast, Pakistan has the lowest lending and deposit rates (both in the low single digit) in nominal terms as well as real terms among these South Asian countries starting from June 2003. Moreover, the spread of the banking system remains moderate in the low single digit. On the contrary, the lending and deposit rates in Sri Lanka have been the highest among these countries in nominal terms. The bank rate in Sri Lanka remains high at 15 percent since 2003 and the commercial lending and deposit rates are above 11 percent and 5.70 percent respectively since August 2005. Therefore, the spread of the banking system remains at a high single digit, the highest in South Asia. Finally, in recent years, the real rates in these countries including Bangladesh have continued to decline due to inflationary pressure.

In recent years, the BB has introduced Repo, Reverse Repo, and the Interbank Repo operations in order to manage day-to-day liquidity positions in the money market and, finally, to strengthen the indirect monetary operations. Figure 1.3.3 shows the recent monthly trends of Repo and Reverse Repo rates. It can be observed that between October 2003 and November 2004, both Repo and Reverse Repo rates remained moderately low compared to January 2005 and onwards. In May 2003, the BB had withdrawn a large quantity of excess liquidity through Reverse Repo operations

The high Repo rates observed again in 2005, originated from the tight liquidity situation that prevailed from January to May and then eased a bit which again become tight in the last quarter of the year. Simultaneously, as in the case of previous years, the BB had withdrawn excess liquidity through higher Reverse Repo rates starting from August 2005. Along with Repo, Reverse Repo, Figure 1.3.3 also shows the monthly trend of weighted average call money rates for the period between July 2002 and February 2006. It can be observed that from July 2003 to December 2004, the call money rate has remained more or less stable in the low


20

27 See Reddy (2005) for an elaboration.

28 The auction of 5-year treasury bill has been discontinued since March 2004.

Figure 1.3.3Repo, Reverse Repo: 1-2 day and 3-9 day, and Call Money

Rates(monthly weighted average in percent)

Note: 1. In the above figure, the discontinuous lines originate from the non-availability of data since auctions were not held in those respective months.


Jul-02

Oct-02

Jan-03

Apr-03

Jul-03

Oct-03

Jan-04

Apr-04

Jul-04

Oct-04

Jan-05

Apr-05

Jul-05

Oct-05

Jan-060

2468

1012141618

Call Money Rate 1-2 Day Repo Rate3-9 Day Repo Rate 1-2 Day Reverse Repo Rate 3-9 Day Reverse Repo Rate


21

single digit, although, in the first quarter of 2003 it was in double digits. In 2005, the call money rate remained in double digits between January and May and afterwards, particularly, from June it fell to a low single digit level up to December. The contributing reason behind this situation is the tight liquidity position in the first half of 2005 and subsequent injections of considerably large liquidity associated with seasonal increased levels of government expenditures. Again in January 2006, the call money rate has reached 15.61 percent although it declined a bit in February 2006 to 12.13 percent. As cited above, these overnight rates have not had a direct influence on the deposit and lending rates.

Since December 1990, in order to rely on market-based tools of monetary management, BB successively used several government treasury bills (e.g., 28-day, 91-day, 182-day, 364-day, 2-year, 5-year, etc.). Figure 1.3.4 shows the movement in the yield rates of government treasury bills with different terms of maturity in recent years.28 Between October 2002 and July 2003, yield rates of all types of government treasury bills remained high in nominal terms. From October 2003 to January 2005, all yield rates remained moderate in low single digits. Starting from February 2005, there has been an increase in all nominal yield rates (less for the 28-day maturity) due to somewhat tight monetary policy pursued by the BB as well as a higher credit demand. In particular, the weighted average yields on 28-day, 364-day and 2-year treasury bills have increased to 7.03 percent, 7.75

Oct-00

Feb-0

1

Jun-01

Oct-01

Feb-0

2

Jun-02

Oct-02

Feb-0

3

Jun-03

Oct-03

Feb-0

4

Jun-04

Oct-04

Feb-0

5

Jun-05

Oct-05

Feb-0

602468

101214

28-Day TB 91-Day TB 182-Day TB 364-Day TB2-Year TB 5-Year TB

Figure 1.3.4Nominal Yield Rates of Treasury Bills (monthly weighted

average in percent)

Note: 1. In the above figure, the discontinuous lines originate from the non-availability of data since auctions were not held in those respective months.



22

percent, and 8.56 percent respectively as of February 2006 compared to 7.00 percent, 7.68 percent, and 8.42 percent respectively in January, 2006. It is worth mentioning that if all yield rates are considered in real terms, a declining trend in real rates is observable in the economy due to a pick up in the inflation rate since the start of FY06.

Furthermore, BGTBs of 5-year and 10-year maturity have been introduced in December 2003. Figure 1.3.5 shows the most recent trend of the nominal yield rates on these bonds. It can be observed that both yield rates in nominal terms have declined a bit since September 2004 with a gradual rise starting from April 2005. In addition to BGTBs, in December 2005, the government as noted already increased the yield rates of term NSD certificates. Particularly, the nominal yield rate on the 3-and 5-year term NSD certificates have been increased by 1.5 percentage points to 11.5 and 12 percent, respectively. Simultaneously, the nominal yield rate on the pensioner certificate has also been increased from 11 percent to 12.5 percent and that on the postal savings certificate from 11.5 percent to 12 percent. In response to these changes, 5-and 10-year maturity BGTBs have also increased from 10.50 and 11.65 percent, respectively, in December, 2005 to 10.60 and 12.09 percent, respectively, in February, 2006. The market for the long-term government bonds appears to be inactive (especially for the 10-year maturity), which may have to wait till the public is able to trade in these instruments in the secondary market.

29 Prepared by Dr. Sayera Younus, Research Economist.

02468

101214

Sep-

04

Oct

-04

Nov

-04

Dec

-04

Jan-

05

Feb-

05

Mar

-05

Apr

-05

May

-05

Jun-

05

Jul-0

5

Aug

-05

Sep-

05

Oct

-05

Nov

-05

Dec

-05

Jan-

06

Feb-

06

5-Year BGTB Rate 10-Year BGTB Rate3-Year NSD Certificate Rate 5-Year NSD Certificate Rate

Figure 1.3.5Nominal Yield Rates of BGTBs and NSD Certificates

(monthly weighted average in percent)

Note: 1. In the above figure, the discontinuous lines originate from the non-availability of data. Source: Constructed based on data from Monetary Policy Department and Economic Trends,

Bangladesh Bank.


23

Finally, it can be concluded that with a reversing of the declining trend of recent years, both the nominal lending and deposit rates in the economy have started to increase gradually since April 2005. However, real lending rates have continued to fall, and the real deposit rate became negative starting June 2004 due to the inflationary pressure, which has already eased to an extent in the last couple of months both on account of moderating price behaviour and the recent increase in the structure of interest rates led by the alignment of rates payable on NSD certificates. The deepening spread between lending and deposit rates of scheduled banks remain a feature of concern, which is further discussed in chapter 3.

(d) Government Borrowing Needs and Outstanding Debt and its Effects on Private Sector Lending 29

(i) Introduction

The goal of this section is to clarify the effects of government borrowing needs on the private sector lending and economic activity in Bangladesh. It has been argued that in a developing country where fiscal dominance works government borrowing from the commercial banking system has two effects; it raises the market interest rate and reduces economic activity in one hand and reduces available funds for the private sector credit and thus further reduces economic activity through the crowding out effect. The


24

former channel depends on the extent of interest rate sensitivity of aggregate demand in the Bangladesh context. The second channel, i.e., the crowding out effect, would partly mitigate if the higher interest rate were to motivate additional savings by the private sector. In the extreme case of low interest rate sensitivity, crowding out holds exactly (i.e., credit allocation become a zero sum game).

(ii) Government Borrowing from the Domestic and External Sources in Bangladesh

In order to finance deficits governments borrow from the domestic and external sources. Among the domestic sources, borrowing from central bank, scheduled banks, and non-bank sources are noteworthy. The consequences of the government borrowing depend on how the deficits are financed. From Table 1.3.1, it can be seen that government borrowing from the external sources are much higher than domestic sources in many occasions.

However a review of 2005-06 (July, 05-February, 06) events Figure 1.3.6 shows the reversal of the pattern; borrowing from domestic sources has dominated external financing. One major reason for this is that, in spite of larger remittances and positive current account balance, financial account suffered particularly due to lower aid receipts thus far in FY06.

(BDT in billion)

Year

Govt. Borrowing fromBanking System

CommercialBanks

BangladeshBank

Sub-Total

Non-Banking Source

DomesticBorrowing

Net ForeignBorrowing

1 2 3 4=2+3 5 6=4+5 71991-92 -4.81 19.19 14.38 8.06 22.44 46.251992-93 2.51 0.46 2.97 11.58 14.54 27.021993-94 -4.38 11.98 7.6 7.51 15.11 83.491994-95 2.44 -3.12 -0.68 10.98 10.3 58.591995-96 17.83 -0.87 16.96 15.97 32.93 -50.761996-97 14.52 2.55 17.07 9.47 26.54 23.431997-98 8.07 4.48 12.55 19.05 31.6 -3.871998-99 10.64 9.12 19.77 27.72 47.49 80.011999-00 17.38 17.86 35.24 32.3 67.54 101.342000-01 20.09 8.95 29.04 42.08 71.13 0.632001-02 27.27 -1.59 25.68 47.11 72.8 120.462002-03 -25.9 16.07 -9.83 47.95 38.13 69.302003-04 16.53 10.16 26.69 45.99 72.68 76.572004-05 38.27 -1.43 36.84 28.58 65.42 81.06

Source: Bangladesh Economic Review, 2005 and ERD.

Table-1.3.1Flow of Annual Government Borrowing


25

(iii) Government Borrowing from the Domestic Sources in Bangladesh

Figure 1.3.7 shows the recent trend in government borrowing in Bangladesh. From Figure 1.3.7, it can be seen that government borrowing from the domestic sources increased substantially during the second half of the 1990's up to the end of FY02. From the above chart it is also evident that government borrowing from other than bank sources has been increasing overtime while borrowing from scheduled banks and the Central Bank follow an irregular trend.

During Feb, 06 claims on Govt. (net) by DMBs stood at BDT 86.70 billion, which was BDT 116.70 billion in Feb, 05, while claims on private sector by DMBs stood at BDT 1223.66 billion in Feb, 06, which was BDT 1052.88

0

20

40

60

July-February, FY06 July-February, FY05

BDT

in B

illio

n

Total Domestic Financing Total Foreign Financing

Figure 1.3.6Recent Trend in Deficit Financing

Source: Major Economic Indicators: Monthly Update, MPD

Trends in Governmnet Borrowing From Domestic Sources

-6000

-4000

-2000

0

2000

4000

6000

Period Claims by CBClaims by SBOther than Bank

1990-91

1991-92

1992-93

1993-94

1994-95

1995-96

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

Tk.

in C

rore

Figure-1.3.7 Trend of Government Borrowing from Domestic Sources

Source: Economic Trends, Bangladesh Bank, various issues.


26

0.00

50.00

100.00

150.00

200.00

250.00

300.00

Real

Gov

t.Cre

dit (

BDT

in C

rore

)

-10-5051015202530

Gro

wth

Real Govt. Sector Credit Real Growth of the Govt.Sector Credit

Figure 1.3.8Real Credit to the Government Sector by the Banking System its Growth Rate

Source: Economic Trend, BB, March 2006.

1995-96

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

30 Real growth rate in the credit to the government sector is calculated dividing nominal credit to the government sector by the GDP deflator at constant prices (Base:1995/96=100)

billion during the same period last year. In growth terms, claims on Govt. and Private sector by DMBs were 25.7 percent lower and 16.22 percent higher respectively from the same period last year. However, Govt. borrowing from the non-bank public through NSD certificate stood at BDT 70.14 billion during July-February of FY06 which was 39.82 percent higher than the same period in the preceding year.

(iv) Real growth in the Credit to the Government Sector from the Banking System 30

Total real credit growth of the government sector during FY97 was 16 percent, which came down to 11 percent during FY97 before increasing to its highest level in FY00 at 20 percent. Subsequently, real credit growth to the government sector slipped down to negative 5 percent in FY03 and again went up to 20 percent during FY05 (Figure 1.3.8).

It is evident from the Figure 1.3.8 that even though real credit to the government sector has been increasing, its growth rate fluctuates mainly due to the relative ease of alternative sources of funds.

It can be seen from Figure 1.3.9 that the total credit from DMBs to the government and private sector are generally mutually exclusive; the higher the government sector credit, the lower is the private sector credit except for FY75 to FY80 and again from FY83 to FY86. It is also clear from the graph that during the last 10 years there would appear some indication of


27

Gro

wth

Rat

e

GRGS GRPS

1974

-75

1975

-76

1976

-77

1977

-78

1978

-79

1979

-80

1980

-81

1981

-82

1982

-83

1983

-84

1984

-85

1985

-86

1986

-87

1987

-88

1988

-89

1989

-90

1990

-91

1991

-92

1992

-93

1993

-94

1994

-95

1995

-96

1996

-97

1997

-98

1998

-99

1999

-00

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

(Jan,

06)

0.00

20.00

40.00

60.00

80.00

100.00

120.00

-20.00

Figure 1.3.9Growth of Total Credit to the Government

Sector (GRGS) and Private Sector (GRPS) from DMBs

Source: Economic Trend, BB, various issues

crowding out. However, it is an empirical issue whether the higher the government sector credit crowds out private sector investment in the Bangladesh context, which ought to be examined formally. In common sense terms, it is easy to argue that if government credit is used unproductively that reduces economic activity and growth, crowding out will manifest itself.

It is interesting to note that during July '05-February '06 period (Table 1.3.2) the nominal growth rate of the private sector credit is 10.57 percent, while the real growth rate is 5.85 percent due to inflation and 4.69 percent in view of the currency depreciation. The real growth rate of the private sector credit was 7.16 percent and 11.62 percent respectively during the same period last year. During July' 05-Feb' 06, inflation was 4.72 percent and currency depreciation was 5.88 percent which were respectively 4.16 percent and -0.30 percent during the same period in the preceding year.

Period

Change inTotal Private

Sector Credit (%)

July' 05-Feb' 06 10.57 4.72 5.88 5.85 4.69

July' 04-Feb' 05 11.32 4.16 -0.30 7.16 11.62

Due toInflation

Due to ExchangeRate Depreciation

Changein CPI (%)

Change inExchangeRate (%)

Change inReal Private Sector

Credit (%)

Table 1.3.2Private Sector Credit Growth, July' 05-Feb' 06

Source: Major Economic Indicators: Monthly Update, MPD and Research Department


28

An analysis of the growth in the total internal debt (Bank and Non-Bank) by the Government and private sector credit growth (Figure 1.3.10) shows that an increase in the total government sector credit reduces fund for private sector, which may lower economic activity, and growth for some selected years. However, the charts cannot indicate any causal process between the variables. It would be necessary to develop an articulated model and obtain additional data to perform such an analysis, which is beyond the scope of this Review.

Finally, Figure 1.3.11 generally shows that total government borrowing from the domestic and external sources reduces growth in the private sector

Figure 1.3.10 Growth in the Total Internal Debt (GIDEBT) and Private Sector Credit (GRPS)

Source: Bangladesh Economic Review 2005, Ministry of Finance

-60

-40

-20

0

20

40

60

80

100

1992

-93

1993

-94

1994

-95

1996

-97

1997

-98

1998

-99

1999

-00

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05G

row

th R

ate

GIDEBT GRPS

Figure 1.3.11Growth in the Total Government Debt (GDEBT) and

Private Sector Credit (GRPS)

Source: Economic Trend, BB, various issues

-10.00-5.000.005.00

10.0015.0020.0025.0030.0035.0040.00

Gro

wth

Rat

e

GDEBT GRPS

1992-93

1994-95

1996-97

1998-99

2000-01

2002-03

2004-05

31 Prepared by Shubhasish Barua, Research Economist.


29

credit, which again gives a general indication that an increase in the total government debt reduces private sector credit, as fewer funds are available for investment in the private sector. While private sector credit has grown in a stable manner since FY97, data for FY98, FY00 and FY02 suggests that the growth of public and private sector credit has been in the opposite directions.

(V) Conclusion

While historically net foreign financing of the national budget deficit has dominated domestic financing, data for FY06 to date indicates a reversal of the pattern. This has presumably been caused by the high cost of energy imports and a concomitant decline in the realized level of official development assistance. Looking back it is seen that most of the domestic financing of public expenditure has occurred through borrowing from the non-bank public (typically via NSD certificates). While the above pattern has generally left the private sector credit growth at a stable level over the past decade or so, FY06 record (July' 05-Feb' 06) suggests that the rate of growth of real private sector credit has been lower than in the recent past. The latter is caused by both domestic inflation as well as the currency depreciation over the past eight months. The most recent episode of enhanced borrowing from the non-bank public has also been accompanied by steep increases in the interest rates in the commercial banking system.

(e) Balance of Payments and the Foreign Exchange Market 31

(i) Balance of Payments

Decelerating import growth coupled with steady export growth narrowed down the trade deficit by 362 million USD at the end of July-March period of FY06, over the corresponding period of FY05. At the same time there was a sharp rise in the services account deficit by (-) 197 million USD, thereby offsetting the improvement in the trade balance. However, it was worker’s remittances, which increased by 653.5 million USD during the nine months of FY06 over the matching period of the previous year that turned the current account deficit to a modest surplus. There was also a marginal improvement in capital transfer during the period under scrutiny (July-March), which increased to 160 million USD in FY06 from 144 million USD in FY05. In spite of considerable surplus in the current account, overall balance fell into deficit of (-) 37 million USD, due to a shift in the financial account, which turned into a deficit account of (-) 78 USD million in July-Mar period of FY06 from a firm surplus of 1297 million USD during


30

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

Perc

enta

ge C

hang

e

Wov

enG

arm

ents

Knitw

ear

Leat

her

Froz

enFo

od

Jute

Goo

ds

Che

mic

alPr

oduc

ts:

10.7714.50

3.25

19.12

13.20

30.84

Figure 1.3.11Percent Change of Export in FY06 over FY05 (Jul-Mar)

the same period of previous fiscal year. This deficit in the financial account is attributable to substantial reduction in the inflow of Medium and Long Term (MLT) loans coupled with sizeable net outflow of short term loans and trade credit.

(ii) Export

It can be expected that in FY06 export earnings will exceed the average growth rate of last three fiscal years, an early indication of which is reflected in the 19 percent growth during the first nine months of this fiscal year over the corresponding period of the previous fiscal year. Knitwear products recorded an impressive growth of 30.8 percent during July-March period of FY06, adding an extra 632.5 million USD. Woven garments that experienced sluggish growth during FY05 (1.7 percent over FY04) also achieved 10.77 percent growth, which makes it likely that the garments sector will reach its growth target for the FY06. At the same time, traditional exports like jute goods and leather, which account for around 3.5 and 2.5 percent share of total exports, achieved 19.11 and 14.5 percent growth, respectively. On the other hand, tea and home textiles are unlikely to meet to the growth target, where tea registered a sharp decline of 22.37 percent and home textiles declined marginally by 0.02 percent during the July- March period of this fiscal year over the last year.

The Monetary Policy Review (MPR), October 2005 suggested that RMG export would remain healthy in FY06, despite stiff global competition in a quota free world. So far, the growth of RMG exports seems to be up to the mark, however, on closer inspection, it appears that both woven garments and knitwear products lost their share in the European countries, while gaining market in US and other countries. Trade restrictions on the import


31

-60.0

-40.0

-20.0

0.0

20.0

40.0

60.0

80.0

Rice

Suga

r

Clin

ker

Cru

de

petro

leum

POL

Ferti

lizer

Iron,

ste

el

and

othe

r

Cap

ital

Mac

hine

ry

30.75

46.52

12.105.08

61.93

27.58

-41.77-53.85

Perc

enta

ge C

hang

e

Figure 1.3.13Percent Change of Import in FY06 over FY05 (July- Mar)

of Chinese garments played some role in attaining export growth in the US market. There is some sign of a diversification of the destination RMG export, as it appears from the available data that during the first three quarters of FY06, around 15.7 percent of total RMG export earnings come from the countries other than EU and US, which previously accounted for around 5 percent share of total RMG export on average.

(iii) Import

At the end of first nine months of FY06 import payments recorded 9.53 percent growth, in comparison to the same period of FY05. One observable fact during the period is that import of capital goods and fertilizer increased significantly, while those of foodstuffs declined.

Import of capital machinery increased by 220.3 million USD (or 27.58 percent); iron, steel & other base metals by 284.4 million USD (or 61.63 percent) and fertilizers by 15.0 million USD (or 5.1 percent) and chemicals by 70.8 million USD (or 19.73 percent), which are important for enhancing domestic production capacity and economic growth. At the same time, import of rice fell sharply by (-) 53.85 percent and sugar by (-) 41.77 percent. Favourable production situation throughout the period along with rise in international price of sugar contributed to the fall in the import of foodstuffs. Latest data shows that volume of rice (Aus and Aman) production increased by 11.7 percent during the July-March period of FY06 over the comparable period of FY05. The above trend of import behaviour is in line with the scenario envisioned in the Monetary Policy Review (MPR) of October 2005. On the other hand, import payments increased substantially for crude petroleum, 114.40 million USD (or 46.52 percent) and POL, 105.30 million USD (or 12.1 percent). It can be argued


32

Jul-Mar FY05 Jul-Mar FY06 Share in Growth

0

200

400

600

800

1000

1200

1400

KSA UAE USA UK

Mill

ion

USD

0

5

10

15

20

25

30

Perc

enta

ge S

hare

Figure 1.3.14Flow of Workers' Remittances from Major Countries in

(July- Mar) FY06 and FY05

that, a tightened monetary policy and the depreciation of domestic currency over the past several months, and favourable weather conditions have helped to limit import growth at a manageable level.

(iv) Remittance

As anticipated in the MPR (October, 2005), the flow of worker’s remittances registered a strong growth of 23.15 percent (or 653.5 million USD) by the end of first nine months (Jul-Mar) of the current fiscal year. Inward remittances from the USA contributed 170.42 million USD (around 26 percent) of this growth of 653.5 million USD, whereas during FY05 this contribution was around 18 percent (of total remittance growth) over FY04 and only around 3 percent during FY04 over FY03. Substantial contribution from KSA (19.7 percent or 128.5 million USD), UAE (12.9 percent or 84.18 million USD) and UK (15.2 percent or 99.3 million USD) also contributed to the growth of remittances during the same period. Besides, there is a large amount of informal remittances through the hundi system, which is believed to exert a negative impact on the growth of remittance inflows in the official channel.

Increased flow of number of workers abroad, improvement in banking services along with enhanced anti money laundering activities and depreciation of the BDT, were perceived to be among the reasons behind this growth.

(v) Foreign Exchange Market

Despite considerable growth of remittances and exports and lowered growth in imports, BDT maintained its depreciating trend against USD in

32 Prepared by Md. Alauddin Majumder, Research Economist. 33 MIX (2006)


33

FY06, with occasional short- term instability in the foreign exchange market. The market unease may be caused by the fact that foreign exchange reserves of the country are not sufficient enough to stabilize the market. Gross foreign exchange reserves of the Bangladesh Bank (BB) reached 2910.35 million USD at the end of March FY06, after reaching its lowest level of the present fiscal year at the end of November FY06 (2416.8 million USD), however, the level is still lower than that of March FY05, 3033.88 million USD. Available figures show that gross foreign exchange reserves, measured in months of imports of goods and services, declined to 2.2 months of import cover in March FY06 from 2.5 in March FY05. USD/BDT exchange rate (period average) stood at BDT 69.56 in March FY06 from BDT 63.46 in the same period of the previous year, thereby depreciating by around 8.8 percent over the corresponding period. In line with the nominal exchange rate depreciation, Real Effective Exchange Rate (REER) index also marginally depreciated from 89.72 in February FY05 to 89.43 in February FY06. Bangladesh Bank sold 383 million USD during July-November period of FY06 to ease the pressure in the foreign exchange market. BB also extended overdraft facilities to commercial banks (NCBs as well as PCBs) facing temporary shortfall in liquidity. During the July-February period of FY06, BB extended 199 million USD through overdraft facilities. Though both the Export/reserve and Import/reserve ratio have increased significantly over the years, the seasonal difference between the demand for imports and supply of foreign exchange from exports and inward remittances fuels temporary instability in the foreign exchange market. Therefore, building up of international reserves through stimulating export and remittances and proper management of imports will be the key factor for the future stability of the foreign exchange market.

(f) Micro-Finance32

Bangladesh is considered a pioneer of microfinance. Worldwide dynamism in microfinance has originated in this country. In the global context the success of Bangladesh’s microfinance activities has reached a considerable height. In 2004, for example, ASA, a major Bangladeshi microfinance institution (MFI), was ranked number 10 in terms of profitability (ROA basis) in the developing countries.33 Over the last couple of decades activities in the field of microfinance were observed to expand at a fair pace in Bangladesh. Table 1.3.3 represents evidence of an upward trend in microfinance activities. Credit arranged by microfinance institutions is getting larger gradually as a share of total private sector credit. Over the

34 Khandker (undated).35 MRRU (2006)


34

period from FY02 to FY05 it grew by 78.24 percent while the growth of total private sector credit was 53.62 percent. In FY05 total disbursement of four largest NGO-MFIs stood to BDT 95.3 billion which was almost double the agricultural credit disbursed by the formal sector.

Microfinance is believed to play key role in improving poverty situation in developing countries like Bangladesh. This belief is substantiated by Khandker's finding that although large scale poverty reduction is not possible by microfinance, it does benefit the poor participants and the local economy.34

In Bangladesh, microfinance operations are being conducted mainly by NGOs, the Grameen Bank and various government agencies including BRDB. Lately, PCBs, NCBs and SBs have joined the foray. Among all microfinance operators the most successful are NGO-MFIs. They have been able to achieve substantial outreach covering a majority of the people who need microfinance services. As of December 2005, cumulative number of beneficiaries, cumulative amount of microcredit and cumulative amount of savings of big four MFIs (Grameen bank, BRAC, ASA and proshika) reached 19.38 million, BDT 583,290 million and BDT 45,440 million respectively.35 The reported recovery rate of NGO-MFIs is well above 90 percent which clearly indicates less risk in terms of loan default in microfinance operation on the part of MFIs than in formal sector finance. The very interesting issue relating to microfinance is the gender ratio. Available data suggests that the number of MFIs' female members is significantly larger than that of male members. The domination of female beneficiaries testifies to the well-known claim that women are more reliable users of capital and hence are more able to repay on time. This has led to a significant empowerment of women in family and society. Microfinance operation typically includes microcredit, micro-enterprise loan, micro-

Outstanding FY02 FY03 FY04 FY05

Private sector total 796.5 903.61039.6 1223.6

Microfinance Institutions(MFIs)* 36.3 43.1 53 64.7

Microfinance as % of private sector credit 4.56 4.77 5.10 5.29

Table 1.3.3Share of Microfinance in Total Private Sector Credit (in billion BDT)

Sources: Bangladesh Bank (2005) and * Includes PKSF, Grameen Bank, BRAC, ASA and Proshika

36 Prepared by Shubhasish Barua, Research Economist.


35

1999 2000 2001 2002 2003 2004

Premiums per capita in USD Premiums in % of GDP

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.0

0.5

1.0

1.5

2.0

2.5

3.0

As

Perc

ent

of G

DP

Per

capi

ta

Figure 1.3.15Per-capita Premium Income and Premium as percent of GDP

insurance etc. It is important to note here that the performance of microfinance operations conducted by government agencies is not at par with the NGO-MFIs.

(g) The Insurance Industry36

After the liberalization of the industry in 1984, the insurance industry today consists of two public sector and sixty private sector insurance companies. These 62 insurance companies are operating in both the life and general (non life) insurance sectors in Bangladesh. The life insurance sector comprises of 18 companies including the state owned Jiban Bima Corporation (JBC) and a foreign life insurance company. The other 44 companies are operating in the general insurance sector including the state owned Sadharan Bima Corporation (SBC). The economic significance of the industry is increasing over the last few years; in 2004 gross premium income reached 0.62 percent of GDP from 0.43 percent in 1999. Over the period insurance penetration in the life insurance sector shows an increasing trend, while the general insurance sector appears to be stagnant. Per capita premium income of the country is gradually increasing over the years, which has increased from 1.2 USD in 1999 to 2.5 USD in 2004 though the figure is considerably lower than that of India and Sri Lanka, 19.7 and 14.2 USD in 2004.

At present there is no unique reinsurance company in the country, which can provide specialized reinsurance services to the life and general insurance companies. As a result, insurance companies are facing problems in dealing with the reinsurance facilities. Both state and private

37 Prepared by Dr. Md. Habibur Rahman, Senior Research Economist. Some parts of this section of the Review are adapted from Beck and Rahman (2006).


36

sector insurance companies are facing increasing competition over the years in underwriting new businesses. Public sector insurance companies (both life and general) are losing businesses to the private sector companies mainly due to their business as usual approach and lack of motivation to flourish. The overall regulatory structure of the industry is underdeveloped and is not competent enough to play its role in the development of the industry. Implementing an effective monitoring and supervision system will be critical in guiding the industry in sound management of businesses, thereby enhancing its role in the development of the financial system of the country.

1.4 The Extent of Financial Development in Bangladesh 37

(a) Background

Financial intermediaries essentially involve the transfer of funds in exchange of goods, services, or promises of future return. Development in the financial sector raises the overall efficiency of the financial institutions. As argued by Ross Levine (1997) that a developed financial system reduces transaction costs, information asymmetries, market frictions and pools risk. A well-developed financial system has been widely understood to be a stimulant in accelerating economic growth by mobilizing savings and facilitating investment in an efficient manner. As “financial development” lacks any precise definitions, following the practice of existing literature [King-Levine (1993a and 1993b), Levine (1997 and 1999), Levine-Zervos (1998), Beck-Levine-Loayza (2000) and Levine-Loayza-Beck (2000)] some indicators of financial development may be used for effective policy formulation, implementation and evaluation. Accordingly, three alternative indicators of financial development, such as domestic credit to the private sector by banks to GDP ratio, total deposits to GDP ratio and broad money (M2) to GDP ratio for Bangladesh economy have been used.

(b) Indicators of Financial Development

Domestic credit to the private sector as a percent of GDP (denoted by cr_y) is one of the popular indicators of financial development. It includes all credit issued to the private sector by all financial institutions which indicates the degree of financial intermediation. This ratio measures the financial resources provided to the private sector through loans and advances, purchase of non-equity securities, and trade credits. The second indicator of financial development is total deposits (demand plus time) as a percent of GDP (denoted by dep_y) which is a relatively broad measure of financial development as it includes all the liquid liabilities of the financial system


37

Bang

lade

sh

Indo

nesi

a

Indi

a

Nep

al

Paki

stan Low

Inco

me

Sout

h As

ia

East

Asi

a

& P

acifi

c

0.0

0.5

1.0

1.5

Private Credit-GDP Liquid Liability-GDP Bank Deposits-GDP

Figure 1.4.1Financial Development Indicators: Cross-Country Comparison

Source: Beck and Rahman (2006)

excluding currency in circulation. A third indicator, broad money as a percent of GDP (denoted by m2_y) is basically the liquid liabilities of the financial system in Bangladesh that includes currency plus demand and interest-bearing liabilities of financial intermediaries. This is the broadest measure of financial development and is considered to be a typical measure of financial “depth”. It also indicates the degree of monetization with respect to the real economy.

(c) Financial Development in Bangladesh: A Cross-Country Comparison

The degree of financial development and efficiency does not provide any meaningful signal to the policy researchers unless some sort of international comparison is made. The extent of the development in the financial sector of Bangladesh has been analyzed with reference to some of the South Asian countries as well as low income countries. It has been observed that the degree of financial development in Bangladesh in terms of banking services is at a comparable level with other South Asian countries and at a higher level than the average for low-income countries. The other segments of the financial system, such as the insurance sector and the stock market are substantially less developed than in comparator countries.

Three aggregate indicators, such as domestic credit to the private sector as a ratio of GDP, liquid liabilities to GDP ratio and bank deposits to GDP ratio have been used to make an international comparison in the development of financial intermediaries, i.e., the development of bank and bank-like financial institutions. Figure 1.4.1 shows that all of the three

indicators of financial development in Bangladesh are fairly close to the South Asian average countries and are significantly higher than the

38 Overhead costs are banks' total operating costs relative to total assets while net interest margins are net interest revenue (i.e. interest revenue from loans minus interest costs from deposits) relative to total earning assets.


38

0

0.02

0.04

0.06

0.08

Bang

lade

sh

Indo

nesia

Indi

a

Nep

al

Paki

stan

Low

Inco

me

Sout

h As

ia

East

Asia

& P

acifi

c

Overhead Costs Net Interest Margin

Figure 1.4.2Overhead Costs and Net Interest Margins (2004)


averages for low-income countries. However, Bangladesh is well behind India in each of these categories. It has also been observed that private credit as well as liquid liabilities to GDP in Bangladesh performed relatively better than that of bank deposits to GDP in the context of neighboring countries.

Overhead costs and net interest margins– two negative indicators of banking system efficiency could also be examined to check the status of Bangladesh.38 It can be observed from Figure 1.4.2 that both of the indicators are at comparable levels with the other South Asian and East Asian countries and significantly lower than the average for low-income countries. Both of the indicators are also seen to be better in Bangladesh than that of East Asia and Pacific, low income courtiers and that of Indonesia. The net interest margin indicator performed significantly well which is the lowest in Bangladesh among the all the countries used in the sample. The overhead cost, however, performs poorly in that it is the highest among the neighboring countries in the sample.

The access to and use of banking services in Bangladesh are also compared with other countries in the region and an average for low-income countries. The evidence for 2004 suggests that banking penetration is adequate for the level of financial and economic development in Bangladesh. Bangladesh has 47 bank branches per 1,000


39

Number of branches per100,000 people

Branches per 1,000 sq km

0 5 10 15 20 25 30 35 40 45 50

IndiaIndonesiaSri LankaNepalPakistanBangladeshLow Income Countries

Figure 1.4.3Branch Penetration across Countries (2004)


Number of ATMs per

100,000 people

ATMs per 1,000 sq km

0 2 4 6 8 10 12

IndonesiaSri LankaNepalPakistanBangladeshLow Income Countries

Figure 1.4.4ATM Penetration across Countries (2004)


square kilometer and four branches per 100,000 people. Figure 1.4.3 shows that geographic branch penetration is significantly higher in Bangladesh than in comparator countries - mostly due to the high population density.

The rate of ATM penetration is another indicator of expanding modern banking. It has been observed that ATM penetration is significantly lower in Bangladesh with less than one ATM per 1,000 square kilometer and one million people. Figure 1.4.4 shows that ATM penetration – both in geographic as in demographic terms – is significantly lower than in any comparator country with the exception of Nepal reflecting limited use of technology in banking sector outreach.


40

cr_y dep_y m2_y i_y y_pcap

5

10

15

20

25

30

35

40

1976-1980 1981-1985 1986-1990 1991-1995 1996-2000 2001-2005

Ratio

/Rate

50

100

150

200

250

300

350

400Pe

r ca

pita

GD

P (U

SD)

Figure 1.4.5Trends in Some Indicators of Financial

Development, Investment and Economic Growth, 1976-2005


Other than the formal banking sector, the performance of microfinance activities in Bangladesh is significantly higher than in many comparable countries. Beck and Rahman (2006) note that microfinance penetration in Bangladesh is the highest in the world, which is twice that of Indonesia. They also mention that other segments of the financial system are significantly less developed than the banking system. There is a small but growing non-bank financial sector comprising leasing and finance companies. Nonetheless indicators of the size and activity of the stock market and life insurance companies in Bangladesh with the comparator countries are not so encouraging, which are reviewed further below in this chapter. Overall, however, the aggregate indicators of financial intermediary development are emerging in a way that is expected to be able to support Bangladesh’s move from a low- to a middle-income country.

(d) Financial Development and Economic Activity Linkage in Bangladesh

With a view to investigating the historical evolution of the above indicators of financial development and its association with investment activities (measured by fixed capital formation as a percent of GDP denoted by i_y) as well as per capita income (denoted by y_pcap) annual data during 1976-2005 are used. The data as presented in Figure 1.4.5 as well as in Table 1.4.1 show that all three indicators of financial development display

steady growth trend during 1976-2005 thus indicating the widening and deepening of the financial system in Bangladesh overtime with a structural break in 1991. Note that the Financial Sector Reform Program (FSRP) was


41

Notes: 1. lr = Weighted average annual interest rate on lending by banks. 2. cr_y = Domestic credit to the private sector as a percent of GDP. 3. dep_y = Total deposits as a percent of GDP. 4. m2_y = Broad money as a percent of GDP. 5. i_y = Gross fixed capital formation (gross investment) as a percent of GDP. 6. y_pcap = GDP per capita at current US dollar.

39 Prior to 1990, the policy was based on direct control over various instruments, such as the volume and direction of credit and interest rates.

launched in 1990 to shift the policy stance gradually towards indirect control.39 Investment as a percent of GDP and per capita income (in current USD) also display a similar pattern and move broadly together reflecting a close association among financial development, investment and per capita income during the period.

It has been observed from the Table 1.4.1 that the average credit, deposit and broad money to GDP ratios increase substantially from 6.6 percent, 14.9 percent and 19.0 percent respectively in 1976-1980 to 28.8 percent 35.01 percent and 40.0 percent respectively in 2001-2005 reflecting steady growth of financial development in Bangladesh. At the same time the investment-GDP ratio as well as income per capita also shares the similar up-ward trend during period. Various scatter plots relating the indicators of financial development and related macroeconomic linkage variables are presented in the appendix to this chapter.

Table 1.4.1Trends in Some Indicators of Financial Development,

Investment and Income


Period lr cr_y dep_y m2_y i_y y_pcap

1976-1980 11.09 6.59 14.86 19.03 10.44 160.0

1981-1985 13.68 13.67 20.23 24.54 10.51 192.0

1986-1990 14.71 19.08 24.75 28.67 13.87 242.0

1991-1995 13.90 16.58 23.07 26.68 17.93 283.0

1996-2000 13.83 23.17 26.70 31.01 21.51 353.0

2001-2005 12.33 28.83 35.08 40.02 22.63 395.0


42

References

Bangladesh Bank (2004), NGO-MFIs in Bangladesh, Vol. 1, December 2004, MRRU, Bangladesh Bank. Bangladesh Bank (2005), Bangladesh Bank Quarterly, July-September, Vol. III, No. 1, Bangladesh Bank.Beck, T. and M. H. Rahman (2006), “Creating a More Efficient Financial

System: Challenges for Bangladesh,” a background paper of the World Bank Study on Bangladesh: Strategy for Growth and Employment.

Beck, T., R. Levine and N. Loayza (2000a), “Finance and the Sources ofEconomic Growth,” Journal of Financial Economics, 58, 261-300.

GOB (2005), Bangladesh Industrial Policy 2005, Ministry of Industry,Government of the People’s Republic of Bangladesh.

GOB (2005), Bangladesh Orthonoitik Samiksma 2005 (Bangla version),Ministry of Finance, Government of the People’s Republic of Bangladesh.

Kazemi, M.A.M. (1998), “Financial Sector Reforms: The BangladeshExperience”, Country paper for ESCAP Seminar on Improved Management of the Financial Sector, 20-22 May 1998.

Khan, Anis A. (2005), “Bridging the Gap Between Micro and SME Finance:Solutions, Instruments, & Technology to Improve Operations,” presented in conference held in Bangladesh-China Friendship Conference Center, Dhaka, November 28-29, 2005.

Khandker, S. (undated), “Does Micro-finance Really Benefit the Poor?Evidence from Bangladesh,” available at http://www.adb.org/poverty/forum/pdf/Khandker.pdf.

King, R. and R. Levine (1993a), “Finance and Growth: Schumpeter Mightbe Right,” Quarterly Journal of Economics, 108:3, 717-737.

King, R. and R. Levine. (1993b), “Finance, Entrepreneurship and Growth:Theory and Evidence,” Journal of Monetary Economics, 32, 513-542.

Levine, R. (1997), “Financial Development and Economic Growth: Viewsand Agenda,” Journal of Economic Literature, 35:2, 688-726.

Levine, R. (1999), “Law, Finance and Economic Growth,” Journal ofFinancial Intermediation, Volume 8, 8-35.

Levine, R. and S. Zervos (1998), “Stock Markets, Banks and EconomicGrowth,” American Economic Review, 88:3, 537-559.

Levine, R., N. Loayza and T. Beck (2000b), “Financial Intermediation andGrowth: Causality and Causes,” Journal of Monetary Economics, 46, 31-77.

MIX (2006), “Microfinance Institutions in Developing Countries-a View ofthe Landscape,” Program-Related Investments Conference, Palo Alto, CA, January 19, 2006.

Reddy, Y. Venugopal (2005), Annual Policy Statement for the Year 2005-06,Reserve Bank of India.

The Executive Times, January 2006.


43

Appendix 1.1: Financial Development vs. Economic Activity Linkage

The scatter-plots for the various indicators of financial development vs. investment-GDP ratio and income per capita have shown in Figures 1.4.6-1.4.8. The scatter-plots of the three indicators of financial development vis-à-vis investment as well as per capita income strongly support the existence of co-movement between financial development and economic activity (Figures 1.4.6 and 1.4.7). Besides, almost a linear relationship is observed in another scatter-plots diagram between investment-GDP ratio and per capita income (Figure 1.4.8).

Figure 1.4.6 Financial Development and Investment Relationship

Trend Line

0

5

10

15

20

25

30

10 15 20 25 30 35 40 45

Deposit GDP Ratio

Inve

stm

ent G

DP

Ratio

Trend Line

0.00

5.00

10.00

15.00

20.00

25.00

30.00

0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00

Credit GDP Ratio

Inve

stm

ent G

DP

Ratio

Trend Line

0

5

10

15

20

25

30

10 20 30 40 50

Broad Money GDP Ratio

Inve

stm

ent G

DP

Ratio


44

Figure 1.4.7Financial Development and Per Capita GDP Relationship

Trend Line

0

100

200

300

400

500

0 5 10 15 20 25 30 35

Credit GDP Ratio

Per

capi

ta G

DP

in U

SD

Trend Line

0

100

200

300

400

500

5 15 25 35 45

Total Deposit GDP Ratio

Per

capi

ta G

DP

in U

SD

Trend Line

0

100

200

300

400

500

10 20 30 40 50

Broad Money GDP Ratio

Per

capi

ta G

DP

in U

SD


45

Figure 1.4.8Investment-GDP ratio and Per-capital Incame Relationship

Trend Line

0

100

200

300

400

500

5 10 15 20 25 30

Investment GDP Ratio

Per-

cap

ita In

cam

e in

USD

chapter 1siteresources.worldbank.org/psglp/resources/chap1.pdf · the financial system in...

Documents